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Private Client Letter - April 2013

What is the role of government?  This question is defining world markets at present.

Most would agree that the government’s role is, broadly speaking, to improve the lot of the individual. Clearly the ‘lot’ of an individual is multi-faceted – freedom, security, etc – but the cornerstone is surely economic wellbeing.

If this is the test, the opening of the monetary sluice gates in Japan is curious.  Japan’s trend growth rate has fallen as the population has peaked and aged, but the fact is that the average Japanese is slightly better off today than 10 or 15 years ago. Bloomberg tells us that real gross domestic product (GDP) has risen by some 9.7% overall since 1995, while the population has increased by just 1.6%, giving a 7.6% hike in real GDP per capita over the period.  During this time, the consumer price index has retreated by 1.7%. Thus the average Japanese is a little richer than in 1995 and the yen in Mrs Watanabe’s pocket buys her family a little more than it did then.

It is consequently not clear why this state of affairs requires the monetary bazooka just announced by the Bank of Japan, equal to 1% of GDP per month (double that of the Federal Reserve).  The country’s new Prime Minister has insisted that the Bank of Japan adopt an inflation target of 2% p.a. However, had the country achieved inflation of 2% p.a. since 1995, prices today would be a hefty 43% higher than they are.

Of course, what Prime Minister Abe is hoping is that the prospect of prices rising will lure Mrs Watanabe to spend her savings and so stimulate the country’s growth rate. However, the high level of savings in Japan is in fact in the corporate sector, not the private sector (personal savings are only 2% of GDP, corporate savings are almost 30%).  In addition, Mrs Watanabe is facing an increase in consumption tax from 5% to 10% in April 2014.

Our further worry is that, with Japan’s public debt already at 230% of GDP, with total interest expense on government bonds absorbing 40% of government receipts, and with the budget deficit of 10% of GDP ratcheting both these percentages up more and more, any rise in inflation that feeds through to interest rates could be very disruptive.

The expansion of the money supply and the depreciation of the yen have lifted markets  and will together provide a short term boost to growth. However, to achieve sustainable progress, Japan needs structural reform – unwinding corporate cross shareholdings to boost competitiveness, a greater openness to foreign investment, improved corporate  efficiency,  increased  labour  market  flexibility. PM Abe has promised structural reform as the third arrow in his strategy after fiscal and monetary expansion and, to our mind, this is the critical part that will determine whether or not the economy really does turn the corner.  The jury is still out.

Virtual opposition

And so Japan adds itself to the list of countries with policies designed to de-base their currencies. In protest, computer geeks have launched a new ‘virtual’ currency, the ‘bitcoin’. It is not backed by any central bank and governments have no power over it, yet increasingly it is finding its way into mainstream culture!  It is being used for everyday items such as food, while a Canadian man has just put his house on the market with a bitcoin price tag.

Those of a more traditional persuasion might be pleased to learn that there is a push in the United States in more than a dozen states to recognise gold and silver coins as legal tender, such is the level of distrust generated by quantitative easing.

The issue of the role of government is being wrestled with in other corners of the globe. Expanding government’s role through a redistribution scheme has been tested in nearly all advanced countries and found to cause mainly self-inflicted fiscal wounds and economic stagnation.  Europe provides the latest confirmation of this.  In Cyprus bondholders and shareholders have been ‘bailed in’ for the first time, and even savings are being used to cover losses. Whether this proves an isolated example, reflecting German disquiet over Cyprus’ reputation as a haven for Russian money, or whether it does represent a fundamental change in public and political attitudes to bank bail-outs, only time will tell. Bondholders are now entitled to ask whether the EU can be trusted - but €uropean leaders are gambling that the region’s bumpy recovery will nevertheless remain intact.

The work-horse camel

In the United States, Democrats and Republicans remain fiercely at odds over the role and appropriate size of government.  Government spending as a percentage of GDP chugged along in the mid 30%s from the late 1970s until the mortgage meltdown of 2008, at which point it surged to wartime levels of 45% of GDP.  It is currently running at 40% of GDP.

U.S. TOTAL GOVERNMENT SPENDING 1900 TO 2016

US-Government -Spending

Source: usgovernmentspending.com

The harsh economic reality is that private sector spending is more productive than that by the public sector: academics estimate that the multiplier effect of public spending is only half that generated in the private sector.

At current levels, the Republicans see the size of the public  sector  as  a  huge  impediment  to growth,  hence their stubbornness in refusing to accede to the Democrat spending demands.   With neither side giving way, the outcome, signed into law in March, is “sequestration” or automatic across-the-board spending cuts of $85bn.

Is this a camel designed by Congressional committees from a horse? However undignified and tortuous Congress’ budgetary  process,  the  outcome  is  a  reduction  in  the deficit – and, what is really interesting, the rest of the country is starting to tackle problems out of sheer frustration.  Some states are adopting their own sweeping reforms as they vie to attract investment and migrants: Kansas has created a position called ‘the Repealer’ to get rid of red tape; Indiana, short of cash, is privatising road- building; nebraska is looking into abolishing corporate and personal income taxes.

American education is widely viewed as mediocre, but is now being overhauled in individual states: tests are becoming more rigorous and teachers are being held accountable for results.

Investment in research & development has recovered back to its previous record of 2.9% of GDP, set at the height of the space race.  The revolutionary shale gas ‘fracking’ technology was mostly driven by entrepreneurs and states like north Dakota, and the resultant low energy costs are ‘billowing the economy’s sails’ (Economist, 16th March 2013).

Regulation, innovation, infrastructure, education.  Each of these is crucial to competitiveness and enabling America to lead the world out of the credit crisis.  Prime Minister Abe: take note!

Sake in the punchbowl

Investors welcomed the combination of America averting the   ‘fiscal   cliff’,   continuing   signs   of   US   economic progress  and  Japan’s  new-found  determination  to  join the quantitative easing party. The MSCI World Equity Index rose by 15.3% over the quarter to 31st March 2013 in sterling terms (a lesser 7.7% in US dollar terms, such was the depreciation of sterling under the baton of Messrs Cameron and Osborne).

Markets are reaching pre-credit crisis peak levels with the massive monetary stimulus clearly supportive.  Should investors worry, or is this rise fundamentally based?

GLOBAL SHARE PRICES AND TRAILING EPS SINCE 2007 MARKET PEAKS (LOCAL CURRENCY)

EPS-since -2007

Source: Citi Research, Factset

In the graph above, the boxes show the change in trailing earnings per share since the 2007 market peak, while the little diamonds show the change in the country’s equity index.

The little diamonds show that US equities are back to the 2007 peak and the UK market almost so.  However, the rise in both markets has lagged the increase in earnings per share!  (Remember that over two-thirds of UK quoted profits are earned abroad...) Thus these two markets’ rise indeed reflects fundamentals and they should be viewed as fairly valued rather than over-valued. In Asia (excluding Japan) earnings per share are up by 28% but share prices are down by 20%.

After such strong performances, a pullback may well eventuate, perhaps as “sequestration” trims America’s economic sails.

What of the longer term outlook?

This unquestionably remains challenging for the well- flagged reasons of excess public sector debt and with the consumer still cautious post the credit crisis and deleveraging. In addition however, despite the Authorities’ best efforts to stimulate spending by holding interest rates at historically low levels, businesses are also holding back on investment.

The  global  economy  experienced  a  massive  three- legged investment boom in the decades of the 1990s and 2000s.  In the 1990s we had technology mania.  In the noughties US  housing exploded. Over both decades fixed investment in the emerging world, particularly China, grew geometrically.

GLOBAL INVESTMENT RATES

Global -Investment -Rates

Source: IRM, BCA

The upshot of this unprecedented capital expenditure has been excess capacity and diminishing returns.  The Bank Credit Analyst calculates that expected real profit growth in the late 1990s was 7% p.a.; now it is only 2%.

It will take time for the world to absorb this capacity, just as it is taking time for the world to de-lever. Interest rates will remain low not just as a result of the actions of the Authorities but also reflecting weak business investment demand.

Recent rises in markets may lull investors into complacency.   However, we believe that the backdrop is still  precarious  and  we  continue  to  pick  our  way through investment opportunities with great care.  We unrepentantly adhere to our approach of conservatively ferreting out sound businesses with a competitive edge and global perspective, bought on a sensible valuation.

These are often not businesses that lead exuberant markets and our performance does deviate from the indices in individual years.   With our global thematic approach, we seek long term value accretion based on underlying cash flow to deliver the real returns, ahead of inflation, that are our objective for our clients.

At present, perhaps not unsurprisingly given the renaissance discussed above, we are finding attractive companies that meet our criteria in the United States. The financial sector remains undervalued and we have invested where appropriate to the mandate. The Citigroup  share price has fallen by 90% since the beginning of the (matched only by HSBC) and is embarking on a significant restructuring. Northern Trust has a ‘European-style’ private bank operating in the US with limited competition.

This is a scarce asset with an exceptional brand and high barriers to entry.  It is a key beneficiary of growth in wealthy households and expected to grow faster than global GDP.
Veritas Report Card

The chart below, prepared independently by Asset Risk Consultants, covers the five years to 30th December, 2012.   The left hand axis shows both our and the aggregate private client fund manager’s average annual returns, while the bottom axis records the risk or volatility. We are pleased to reflect that the returns achieved by Veritas (the red shapes) significantly exceed the returns recorded by both the peer group (the white shapes) and by markets (the line).

Report -Card

Source: Asset Risk Consultants

The risk in our High Equity client portfolios has been so low relative to the peer group that ARC has re-classified them into their next lower ‘Steady Growth’ risk category.

Meg Woods
8th April 2013

ARC Private Client Indices (“PCI”) are based on historical information and past performance is not indicative of future performance. PCI are computed using a complex calculation and the results are provided for information purposes only and are not necessarily an indicator of suitability for your specific investment or other requirements. ARC does not guarantee the performance of any investment or portfolio or the return of an investor’s capital or any specific rate of return. ARC accepts no liability for any investment decision made on the basis of the information contained in this report. you should always complete your own analysis and/or seek appropriate professional advice before entering into an agreement with any PCI Data Contributor. The content is the property of ARC or its licensors and is protected by copyright and other intellectual property laws. Use of the information herein is governed by strict Conditions of Use as detailed on www.assetrisk.com/pci.

The above review has been issued by Veritas Investment Management LLP, which is authorised and regulated by the Financial Conduct Authority.

The opinions expressed above are solely those of Veritas Investment Management LLP and do not constitute an offer or solicitation to invest.

The value of investments and the income from them may fluctuate and are not guaranteed, and investors may not get back the whole amount they have invested.